There’s no such thing as a free lunch. That is especially true in the financial services industry. Brokerage firms charge commissions to trade stocks and advisory firms charge annual fees to manage a portfolio. There really is no escaping pay-to-play fees in the market.
Mutual funds and exchange-traded funds (ETFs) are loaded with fees. There are expense ratios, 12-b1 fees and purchasing fees. With most funds now trading on a no-load basis, the biggest of these fees is the expense ratio. Given that most funds pay operating expenses out of fund assets, it is the investor that indirectly pays these expenses.
Among the thousands of funds in the marketplace, there is a wide disparity in expense ratios. Smaller funds tend to have higher expense ratios because asset levels are not sufficient to pay fund expenses. As the fund grows, the total expense ratio will decline. Because newer funds tend to have fewer assets, they also will have the higher expense ratio as compared to older and larger funds.
Even larger and more established funds have wide discrepancies in expense ratio. In 2010, the average stock mutual fund expense ratio was 0.84%. Within that average is a wide variance. Index funds have expense ratios as low as 0.2% as they are able to eliminate the cost of active management. On the high side, many stock mutual funds have expense ratios above 2%.
That is a big gap investors need to pay attention to. If an actively managed fund charges 2 percentage points more than an index fund, that fund would have to outperform said index by that much or more to make it a worthwhile investment. If the performance is not there, those higher expense ratios can eat away at a portfolio.
Let’s assume you have a portfolio of $100,000. Paying 2 percentage points more per year more than an index fund that is generating the same returns would result in an extra expense of $2,000 per year. Over a 10-year period you would be down $20,000. That is a big chunk of change for any investor.
Of course, paying that extra fee makes sense if your fund is outperforming the market. Just keep in mind that a professionally managed fund is likely to have a higher expense ratio and that expense will eat into your returns.